Operational and Actuarial Aspects of Takaful

Retakaful

Sub Topics
Basic Principles
Retention Capacity Classes of Retakaful Retakaful v Reinsurance Certificate Issuance Methodology

Introduction
Adverse Claims experience is influenced by:
Major losses of the individual risks Major losses arising from a single event

High frequency of many small losses

Change in risk structure (technological, economic,

social and political)

Elements of Reinsurance
Reinsurance is a type of insurance but is a distinct and separate contract from the original insurance and itself takes the form of a contract of insurance. Reinsurance may cover part of the ceding companys portion, but no more than that. The reinsurance contract must cover the same risk as the original insurance. Both insurance and reinsurance policies are to be in existence at the same time.

Elements of Reinsurance
The co-existence rule seems to have been dispensed as decided in General Accident Fire and Life Assurance v. Tanter, The Zephyr (1984), where the reinsurance had been placed before the insurance. In both practice and law, The Zephyr confirms that an undertaking to indemnify against future liability is coherent with the objectives of reinsurance.

Basic Principles
Same as insurance; namely Indemnity, Utmost Good

Faith, Insurable Interest, Subrogation, Contribution and Proximate Cause. In particular, the 3 principles apply directly in the case of reinsurance; Indemnity, Utmost Good Faith and Insurable Interest.

Indemnity
Putting the insured in the same financial position as he/she was, before the insured event.
The real limit of indemnity is the extent of the cedants insurable interest. The amount recoverable from reinsurance relates to the corollary of indemnity, which is the average clause

Why Retakaful
Risk spreading
Capacity boosting Financial advantage Financial stability Protection against catastrophic risks

Retention
Defined as the limit of liability, usually expressed as a monetary amount, which the insurer retains for its net account after reinsurance. Also be defined as the maximum amount that the insurer is willing to pay for a loss affecting a policy, risk or group of risks". The retention may apply to a single risk or a series of risks, or to a single loss or series of losses.

Retention
Retentions are usually fixed based on each class of business separately

(family, fire, accident, marine, aviation, etc.). the various classes.

There may also be an overall retention over the combined portfolios of

There is only an optimal retention for each takaful operator. The

optimal retention will provide the takaful operator a framework in which to achieve its particular corporate objectives.

Takaful operators with similar portfolios but having different corporate

aims will likely to have different retention levels.

Retention
1. 2. 3. 4. 5. 6.

The factors for consideration: Size of the operator Contribution income, size of portfolio and profitability Financial strength of the operator Reinsurance/retakaful type and cost Claims experience Corporate strategy

Classes of Retakaful/Reinsurance

Treaty

Proportional
1. 2.

3.

quota-share surplus (above retention limits) facultative obligatory excess of loss stop loss Catastrophe loss

Non-proportional
1. 2. 3.

Classes of Retakaful/Reinsurance
Facultative (individual basis)
Proportional 1. quota-share 2. surplus

Non-proportional 1. excess of loss

Financial Re - focused more on capital management than on risk transfer. Captive Re

Treaty
Sufficient flow of retakaful The primary consideration that the portfolio may be

exposed to large individual losses More convenient as all risks accepted by the ceding operator requiring retakaful falling within the scope of contract will be automatically covered.

Treaty Which Type?

Factors to consider : 1. Type of coverage 2. Administrative costs & ease of operation 3. The effect on net retained premium income 4. Whether to control exposures or ease the financing of solvency 5. Whether to engage in reciprocal business

Treaty Pro or Non Pro?

Proportional
A surplus treaty is technically the best arrangement to deal with

large individual risks on classes of business with fixed sums covered and the ceding operator can retain part of the biz
However, a surplus treaty requires considerable amount of skill and

time in its administration, and as such may induce a ceding operator to place retakaful on a risk excess of loss basis.
A quota share treaty usually will carry a higher rate of retakaful

commission than a surplus treaty.

Treaty Pro or Non Pro?

Non Proportional
Excess of loss & quota share treaties are much cheaper

and easier to operate

For added stability, stop loss retakaful may be

considered for the protection of classes of takaful exposed to large-scale fluctuations in aggregate annual claims.

Facultative

Generally, facultative placement is necessary in the following circumstances: The risk falls outside the ceding operators treaties, such as outside geographical area or an excluded class of risk The sum covered exceeds the treaty limit The ceding operator does not want to cede the risk to the treaty The risk is unattractive to be offered on a treaty basis The takaful operator wishes to accommodate a special case that may fall outside the scope or limits of its treaties The takaful operator does it for unique commercial, financial or strategic reasons

1. 2. 3. 4. 5. 6.

Facultative - Advantages
Risks are considered individually;
It increases the takaful operators competitive edge in that particular line; There is freedom to offer any risk which may be accepted or declined; A particular account may be further protected by use of facultative retakaful Transfer of knowledge and technology

Facultative - Disadvantages

The takaful operator may not be able to place the risk The process is more complicated and involves more administration There could be errors in placement Cover cannot be confirmed until placement is effected

How much to Reinsure?

Proportional Quota share Surplus treaty Non Proportional Excess of Loss Stop Loss

Quota Share
A company may only be able to offer $1 million in coverage, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and losses are then shared on a pro rata basis.
For example, an insurance company might purchase a 50% quota share treaty; in this case

they would share half of all premium and losses with the reinsurer. In a 75% quota share, they would share (cede) 3/4 of all premiums and losses.

Quota Share
Advantages
the relationship between cedant and the

reinsurer/retakaful operator is absolute - in such a context the reinsurer/retakaful operator follows the fortunes of the cedant almost identically the accounting and reporting of business is simple flexibility exists in increasing or decreasing the amount of quota share ceded; i.e. the cedant may vary the quota share unlimited cover is provided for aggregation of risk losses in a single loss event

Quota Share
Disadvantages since a quota share involves the cession of all business within the retention pattern, large amounts of income are ceded away - this could be to the detriment of the cedant a quota share treaty is inflexible as the cedant has no choice in selecting a retention limit.

Quota Share
A quota share treaty is more appropriate new takaful

operators, or developing a new line or class of business, or for experimental or special where the reinsurer/retakaful operators' expertise is needed

Surplus Treaty
The operator transfer the amount of risk above its retention

limit (defined as a line). Retakaful operator will accept the part of every risk that exceeds the operators retention limit automatically. The latter shares in contributions and losses in the same proportion as it shares in the total limits of the risk.

E.g. An operator issues a cert for $20,000. It keeps $5000

() and transfers the remaining $15,000 () to its Retakaful. This is called a three line surplus because the amount transferred equals three times the retained line of the operator. It keeps and transfers of the contribution to the Retakaful.

Surplus Treaty
In the event of total loss, the settlements between the two

operators would be effected on the identical - basis. If there is a partial loss, the Retakaful must reimburse the operator in the same proportion as the reinsurance contribution received.

E.g. In a 9 line surplus treaty where retention limit is

$100,000 the reinsurer would accept up to $900,000 (9 lines). So if the insurance company issues a policy for $100,000, they would keep all of the premiums and losses from that policy. If they issue a $200,000 policy, they would cede half of the premiums and losses to the reinsurer (1 line each). The maximum underwriting capacity of the cedant would be $ 1,000,000 in this example.

Surplus Treaty
The larger the number of lines, the higher the retakaful

operators obligation

It reduces the retained loss cost on larger risks and limit the

loss on any one risk. It provides the cedant a larger retained contribution for the same retention limit on any one risk, therefore providing better balance. to enable the cedant to transact business in its chosen market and compete with its peer operators.

Main purpose is to attain automatic underwriting capacity

Surplus treaties are also known as variable quota shares.

Surplus Treaty
Advantages:
a surplus treaty allows the operator to vary its retention

upon a particular risk; there is automatic capacity available upon a particular class and size of risk; the operator is allowed to retain a greater proportion of its income this aspect would be diluted if the cedant chose to effect any quota share reinsurance/retakaful on all or selected parts of its account.

Surplus Treaty
Disadvantages:
the operator stands or falls by its chosen retention - this

is a fundamental calculation for the cedant comparison of results between the cedant's net results and those of its surplus reinsurer/retakaful operators might be different - whichever way they fall might influence the original construction between the cedants net and gross accounts and the benefit which the cedant should obtain from such arrangements.

Facultative Obligatory
is used for a substantial number of individual facultative cessions Treaty are concluded in advance and the cedant has the option to cede risks to the treaty. The obligatory element rests with the reinsurer/retakaful operator, who must accept such cessions once they are made Tend to generate small incomes for a large capacity

Facultative Obligatory
Advantages
Provides the cedant flexibility and complements existing

automatic treaty facilities, and such facilities follow the cedant's gross retention pattern. The cedant also benefits from the knowledge that it should be offered a risk larger that its capacity, Treaty would offer sufficient automatic underwriting capacity hence the cedant would not have to resort to the extensive administration required in making an individual facultative placement.

Excess of Loss
It will either limit the individual retained loss, or the accumulation of retained losses from one event, or the aggregation of retained losses over a period The stop loss limits the total claims over a given period of time, normally on an annual basis. Under aggregate excess of loss, it is normal if only individual claims in excess of a certain figure will be included in the deductible

Excess of Loss Example

The insurer is prepared retain a loss of $1 million for

any loss which may occur and they purchase a layer of reinsurance of $4 million in excess of $1 million. If a loss of $3 million occurs, the insurer pays the $3 million to the insured, and then recovers $2 million from its reinsurer(s).

Excess of Loss
Excess of loss reinsurance can have three forms
Per Risk XL (Working XL) Per Occurrence or Per Event XL (Catastrophe or Cat

XL) Aggregate XL

Per Risk XL
For example, an insurance company might insure commercial property risks with policy limits up to $10 million, and then buy per risk reinsurance of $5 million in excess of $5 million. In this case a loss of $6 million on that policy will result in the recovery of $1 million from the reinsurer.

Per Event XL
For example, an insurance company issues homeowner's policies with limits of up to $500,000 and then buys catastrophe reinsurance of $22,000,000 in excess of $3,000,000. In that case, the insurance company would only recover from reinsurers in the event of multiple policy losses in one event (i.e., hurricane, earthquake, flood, etc.).

Aggregate XL
Company retains $1 million net any one vessel, the cover $10 million in the aggregate excess $5 million in the aggregate would equate to 10 total losses in excess of 5 total losses (or more partial losses). Aggregate covers can also be linked to the cedant's gross premium income during a 12 month period, with limit and deductible expressed as percentages and amounts. Known as "Stop Loss" or annual aggregate XL.

Retakaful v Reinsurance
Reinsurance law derives largely from English law whilst retakaful is based on the Shariah (the retakaful contract between takaful operator and the reinsurer/retakaful operator, must comply with Shariah).
The question now remains; which jurisdiction does it fall under, especially if reinsurer/retakaful

operator is based in a foreign country),

Retakaful v Reinsurance
Contracts between takaful operators and reinsurers/retakaful operators just mirror exactly the conventional reinsurance contract (non shariah compliant) Issue of profit commission or experience refund do not comply to shariah or follow the principles of takaful. As for the solid financial standing and technical advisory services, retakaful operators themselves mostly retro-takaful to leading conventional reinsurer.

Retakaful v Reinsurance

1. 2. 3. 4.

Retakaful with conventional reinsurer to be subjected to the following conditions: The retakaful has not enough capacity Arrangement should be of a temporary nature and agreement should be reviewed periodically. As far as possible, contract between the takaful operator and the reinsurer should comply with Shariah. Inward retakaful from insurers can only be accepted if it is conditional on outward retakaful subject to conditions (1) and (2).

Contracting of Retakaful

1. 2.

3. 4. 5. 6.

Normal to use Brokers (in General Biz) whose services include: As an adviser to help construct the program To identify the potential markets for the business and the security of reinsurer/retakaful operators Undertake the marketing & placement of the business Prepare contract wordings As arbiter in the event of disputes arising Administer the program, including the collection & transmission of contributions, and claims settlements

Challenges of Retakaful
New sometimes no/low security rating Services underdeveloped Different Models Lack of Expertise Shariah, Actuarial and

Underwriting

Pricing Considerations
In pricing for non-proportional retakaful, both general and family,

retakaful operators must take the following factors into consideration : Claims experience Original underwriting limits of the cedant The basis of these limits Nature of the account Effect of inflation Currency fluctuations Risk profiles of the portfolio of business Catastrophic perils Underlying protections Amount of cover Relationship with the cedant Quality of business

Financial Re
'Financial reinsurance' were basically funded whereby the

reinsurer agreed to pay an agreed schedule of loss payments in the future in return for the ceding operator paying specified premiums based on the net present value of the loss payments. Therefore, 'financial reinsurance' is not actually insurance contracts but falls under the ambit of banking contracts. In this respect, authorities such as insurance regulators and tax authorities decided that these contracts do not qualify as insurance contracts as there was insufficient transfer of risk.

Financial Re
Finite risk reinsurance will resemble traditional insurance

if the elements of both timing risk and finite risk are greater. Finite reinsurance contract should also have the following characteristics :
Make explicit allowance in the price for investment earnings;

The cedant usually is allowed to share in any profit, but conversely

is required to contribute to any loss under the contract; A limit is usually placed on the aggregate loss payable by the reinsurer operator. May be arranged on either pre-funded (prospective) or post-funded (retrospective) basis.

Financial Re
Retrospective covers - These address losses that have arisen

on contracts written in previous underwriting years. They include Loss Portfolio Transfer, Adverse Development and Retrospective Aggregate Excess of Loss covers.
Prospective covers - These address losses arising on

business written in future years. They aim to smooth the results of future underwriting tears by mitigating serious increases in losses that may occur in the future. They include Finite Quota Share and Spread Loss treaties.

Financial Re
The Catastrophe Risk Exchange, also known as CATEX, was established in 1996 in New York to enable insurers, reinsurers and intermediaries to trade tranches of insurance portfolio. It is an online system that enables insurers and reinsurers exposed to catastrophic losses in one geographical area to trade part of it with others who are exposed in other areas. All Lloyds syndicates have access to the system.

Financial Re
A Catastrophe Bond is a form of corporate bond where the holder agree

to forgo or defer the payment of interest and/or of principal if a defined loss event or experience occurs that exceeds a specified trigger. exchanged for a series of floating payments whose values depend on the occurrence of an insured event. transaction, which is activated by a double trigger of both industry losses and losses incurred by the cedant, both exceeding pre-specified thresholds.

Catastrophe Swaps are a series of fixed, pre-defined payments in

An Industry Loss Warrant is similar but is structured as a reinsurance

Financial Re
Finite reinsurance recognized as an appropriate form of risk transfer but there is concern whether they are properly accounted for in a manner that reflects economic reality. Problems are when finite reinsurance is abused, such as when it is used as a "low cost loan that flies below the regulatory radar" and when its effect is to transform a company's income statement and balance sheet in a way that does not "reflect economic reality."

Reinsurance Reserving
The delay between the claim, intimation, settlement and reporting dates necessitates that the retakaful operator set up "reserves" in respect of those claims still to be settled as in the case above.
The problems of loss reserving are further compounded by a persistent upward development

of most claims reserves.

Reinsurance Reserving
Inherent problems:
Claims data are limited, particularly for retrocession business; The numbers of claims and individual claims information are often not be available, particularly for proportional business.

It is difficult to develop a good loss development pattern as the data is heterogeneous and sub-dividing the data into too small groups, to improve homogeneity, can give rise to excessive volatility.
The development of claims data is generally medium/long-tailed

The length of tail also means that development factors to ultimate which too large and sensitive to be reliable especially in the early periods of development.
Different underlying currencies and inflation rates may distort aggregated data;